Understanding Strip Options Strategies – Profit, Break-Even, etc.

strip option strategy: Trading options in the financial markets can be quite rewarding, but it can also be difficult. Fortunately, different types of strategies are implemented to profit in different market conditions. One strategy you need to know is the strip option strategy.

In this article, we will look at a bearish bias neutral options strategy, namely the strip option strategy. Let’s expand our knowledge of options strategies by understanding the structure of their work through the example of a strip strategy.

What is a Strip Option Strategy?

The Strip Options Strategy is a three-legged, bearish market-neutral strategy designed to perform in volatile, downtrending markets.

In this strategy, one ATM (cash) call option and two ATM (cash) put options are purchased on the underlying security with the same expiration date.

This strategy is deployed when the underlying security is expected to decline or rise significantly. But perhaps a downward movement is more expected than an upward movement. Basically, the strip strategy is similar to the straddle option buying strategy with some modifications.

working model

To deploy a strip option strategy, you need to construct a band of required options.

The legs are as follows:

• First leg:- Buy 2 on cash (ATM) put option exercise. (Here, the strike price closest to the spot price is selected.)
• Second leg:- Buy one in the money (ATM) call option exercise. (The same strike price is considered in the first leg)

yes

Let us take an example to clearly understand the above configuration.

Assume Nifty 50 is trading at spot price 19580. We believe that the market is expected to move significantly down or up with high volatility.

However, since we are more biased towards the downside, we will deploy a strip options strategy.

Here the 19580 spot price is rounded to the nearest strike price of 19600.

The option legs for a nice 50 hypothetical spot price of 19580 are as follows:

1. Buy 2 lots of 19600 strike put option with a premium of Rs 68. If you buy 2 lots here, the total premium amount is 68+68=136 Rs.
2. Buy 1 lot of 19600 strike price call option at a premium of Rs 45.

Here, the total premium is calculated by adding up the premium paid in both buy segments. In the above example, the total premium account is Rs.181. That is, 136+45 = 181.

The margin required to deploy this strategy is less compared to other options strategies. When we purchase a contract here, we need a margin to cover the premium paid.

In the above example, the total premium paid is 181 and the margin is calculated as 181 x 50 (quantity of 1 lot) = Rs. 9050.

maximum profit and maximum loss

• The maximum profit from this strategy is unlimited. Profits increase as the price of the underlying security moves away in either direction from the strike price.
• If the underlying security expires at the strike price, your maximum loss will be the total premium paid. That is, 181 x 50 (quantity of 1 lot) = Rs. 9050 (margin payment 100%).

Break-even point

This strategy consists of two break-even points.

• Upper Breakeven Point = Strike Price + Total Premium.

That is, 19600+181= 19781. If the spot price moves above this point, the strategy will start to become profitable.

• Lower breakeven point = strike price – (total premium / 2).

That is, 19600 – (181/2)= 19509.5. If the spot price falls below this point, the strategy begins to make profits.

reward chart

From the payoff chart you can understand:

• If the price of the underlying security expires between the upper and lower breakeven points, the strategy will incur a loss.
• The strategy profits if the price of the underlying security is above or below the upper and lower breakeven points, respectively.

Advantages

• Profits are generated when the underlying security moves in either direction.
• Margin requirements are lower compared to other strategies.
• Option legs can be adjusted based on the trader’s view of the market moment for higher profitability ratios.

disadvantage

• To generate a profit, the price of the underlying security must change significantly.
• The loss incurred is 100% of the margin required for this strategy.
• Time decay has a negative effect on option value.

Finishing

After understanding the strip options strategy, we can conclude that this strategy has varying scope and application when there is a large upward or downward movement with increasing volatility.

Theta collapse can have such a big impact on your strategy that you could lose the entire premium you paid if the price doesn’t move in the direction you expect.

A better understanding of options strategies allows you to improvise setups for good risk-reward ratios through better risk management.

Written by Deepak M

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